Evidence of Conditional Conservatism: Fact or Artifact?

Abstract

The differential timeliness measure proposed in Basu (1997), which estimates the fraction of observed bad news reported in contemporaneous earnings minus the corresponding fraction for good news, has been used widely to study conditional accounting conservatism. Timeliness is measured as the slope from a regression of earnings, scaled by lagged price, on returns. We find that differential timeliness estimates are biased by two empirical regularities related to lagged price, the deflator in the timeliness regressions: it is negatively related to a) the variance of returns, and b) the probability of a loss, and the magnitude of price-deflated losses. Even though these regularities are unrelated to conditional conservatism, their effects are substantial and pervasive. Also, prior findings regarding time-series and cross-sectional variation in differential timeliness are confounded by corresponding variation in these regularities.